Goldbugs: people investing in gold

Ray Dalio, founder of Bridgewater, the largest hedge fund in the world:

Gold is a very underowned asset, even though gold has become much more popular. If you ask any central bank, any sovereign wealth fund, any individual what percentage of their portfolio is in gold in relationship to financial assets, you’ll find it to be a very small percentage. It’s an imprudently small percentage, particularly at a time when we’re losing a currency regime.

Gallup polls indicate up to 30% of the US population believes gold to be the best long term investment.

During the Covid pandemic, almost half of Americans either bought gold or precious metals, or were considering it. Erb et al. 2013

What is gold

Gold is a chemical element with symbol Au (from its Latin name Aurum), a metal. With atomic number 69, it is effectively one of the naturally occurring elements on our planet. While it occurs naturally, it is relatively rare in the Earth’s crust.

Where does this “natural” gold metal come from? It is believed that gold is produced in supernova nucleosynthesis as well as in the collision of neutron stars — is was present in the dust from which our Solar system was formed. It is further believed that most of the gold present on Earth is contained in the molten core of our planet, with only residual amounts, possibly brought onto our planet much later on by asteroids from space, accessible to us through the mining industry.

As a metal, gold is resistant to many acids, including nitric acid. Some of its naturally co occurring elements, like silver, as well as many other metals, are not resistant to nitric acid. As a result, nitric acid has been used to separate gold from these other metals, to confirm the presence of gold, and to refine gold. It is from this that we derive the widely known expression of an “acid test” (which is also a concept in accounting as some of you will recognize).

The largest gold producers are China, Australia, Russia and the US. Every year, the world’s supply of gold increases by only 1.5%, a percentage that is expected to further decrease in future years.

Gold history

Gold artefacts, used by humans, were found in Spanish caves dating back 40.000 years. However, we believe the gold industry started thriving in the 5th millennium BC in Mesopotamia (5000 years before our era, or 7000 years ago), with smelting developed in the 4th millennium BC (6000 years ago). From around this time, we found extensive artefacts of gold objects in both the Middle East and the Balkans in Eastern Europe. We know that gold has been prized by humans for at least 7000 years, but possibly well more. It is important to take a step back and realize that for over 7000 years, humans and their kingdoms, empires and civilizations have used and coveted this metal. There are few investments that have the same “historical pedigree.”

Gold also appears in many religions as a result — it is referenced many times in the Old Testament, as well as the New Testament, being for example one of the gifts the magi brought to Bethlehem when Jesus was born.

In Latin America, the Aztecs believed gold was literally the gods’ poop or “teocuitlatl.”

And over time, it motivated many global developments, from the Spanish conquest of Latin America, to the Californian gold rush — which as many of you probably know, is also the birth of the jeans/denim, a very tough material developed for Californian gold diggers at the time, and that you are probably also wearing while reading this (yes I know, some of you are in your underwear or even commando on your beach house — very good).

What is incredible in spite of this long history, is that throughout human history only about a cube of 21 meters per side of gold (21m x 21m x 21m, or about 8000 cubic meters, or about an Olympic swimming pool, or about 190.000 tons) have been extracted, mostly in the 20th century. This is all the gold that exists above ground in the world today.

As of 2013, this global gold had a total value of 9 trillion US dollars. Compared to the value of global stock markets, or government debt, or companies’ debt, it is a tiny amount. By definition gold is constrained to be a small asset class.

Gold as a currency

We know that gold bars were used as a medium of exchange (money) in Mesopotamia going back to the 7th millennium BC (9000 years ago).

The time of Midas, around 610 BC (2600 years ago), saw the world’s first coinage in a province of Asia Minor — Greece at the time, modern Turkey today — called Lydia: the widespread adoption of coins as currency. A century later, on another side of our planet, we know that the Chinese state of Chu started using the Ying Yuan, a square gold coin.

The Roman empire vastly improved gold extraction and metallurgy, mining gold mostly in Hispania (modern Spain) and Dacia (modern Romania). Due to its expanse and power, the Roman currency was used across a large part of Eurasia and North Africa, and it also influenced the currencies of the Muslim Caliphates, along with the European kingdoms of the Middle Ages. The Arabic dinar, the British pound, and the Mexican peso, all derive their names from Roman currency.

Do you want to hear something really cool? In the 14th century (1300–1400), Mali was a wealthy and powerful kingdom. And Mansa Musa was its influential ruler. In 1324, he passed through Cairo on his way to Mecca for the pilgrimage. His caravan included a hundred camels and a thousand people. And he spent so much gold in Cairo that he decreased the value of gold for a decade, causing significant inflation in Egypt as a result — a true high roller.

It is a fact that until the late 19th century, physical gold and silver (i.e. coins) were literally the world’s money / currencies.

Gold as a currency backer

While gold has been used as a medium of exchange for thousands of years, and as a currency for at least 2600 years, the 19th century saw the beginning of gold-backed bills and certificates. These were effectively paper money like we use today, but backed by physical gold. This means that for every dollar bill in circulation, the government/central bank would hold a certain amount of gold in its coffers, and it would guarantee to convert you that bill in gold if you so desired.

After the second world war, in 1944, we had the Bretton Woods agreements, which fixed the price of currencies in gold — for example it was decided, and fixed, that US 35 dollars would be equivalent to 1 ounce of gold. Each currency had a similar conversion ratio into gold, decided by governments, which were effectively the sole party deciding the price of gold. Currencies in the Western world continued to be paper money backed by physical gold until 1971, and even until 1999 in places like Switzerland (those rich Swiss…). Effectively, for every dollar/euro/peso bill available in such a system, there needed to be a specified quantity of physical gold available in the central bank’s vault. Money was exchangeable for gold. And between 1933 and 1974, the private ownership of gold was forbidden in the US and many other countries.

As a result of this history and its use as a store of value, central banks around the world still own large gold reserves. The largest ones are the New York Fed and the Fort Knox vaults in the US, amounting to 3% of the world’s reserves each (I know what you’re thinking: don’t, you are no Professor). But most central banks around the world have similar physical reserves of gold in their coffers (yes, exactly as in Casa del Papel).

Gold floating freely

In 1971, the United States, under Richard Nixon, announced they will stop ensuring the convertibility of their currency, the US dollar, into gold at a fixed price. This represented the end of the Bretton Woods agreements (as we saw above, a global monetary system relying on currencies being convertible into gold and governing the monetary and financial system between the US, Western Europe, Australia, Japan… after the second World War).

As such, our modern currency systems, that do not rely on gold (such systems are called fiat currency) have only about 40–50 years of history. Before, until just 40–50 years ago, we used gold either directly or indirectly as a national currency.

Put another way, gold has traded freely in modern times for only about 40–50 years. It is for this reason that it is difficult to study the price of gold for more than this period, since it was not freely traded previously — it was more a monetary instrument for governments, than an investment or trading asset for individuals. As such, when I look at historical gold prices, I do not go back before January 1975, when it became legal for American citizens to hold gold (as it happened in many other countries around this same period).

Uses of gold today

50% of the world’s gold is used in jewelry, 40% in investing, and 10% in industrial uses. As such, while some real assets are said to be of no real use, gold certainly has real, non financial, uses.

However, these real industrial uses are far from representing 100% of the global supply of gold, and their demand over time is relatively constant and predictable. For example there is very little chance that next year the global jewelry industry will need 50% more gold than predicted, pushing up the price. We know with a high degree of certainty what the global demand for gold from jewelry and industry will be next year. The price of gold therefore fluctuates mostly with investors’ demand.

At the time of writing, global central banks hold about 20% of the world’s gold reserves in their vaults.

Geographically, the largest consumer of gold is China, followed by India, and about one fifth of the world’s gold is held by central banks in their vaults.

Why do people hold gold?

In addition to almost all professional asset managers, about 12% of the American public owns gold as an investment — more than one in ten Americans, or about 35 million people.

a. Store of value

As we saw, gold has been used as a store of value for possibly 9000 years now. That’s certainly a very very long history. The characteristic of a store of value is simple: it at least retains its value, it stores it, as time passes and the world changes. For example is a car a store of value? Since the moment you buy a new car it loses a large part of its price, and every year and every km it loses more value, clearly it is not a good store of value. You want things that retain their value over time, or possibly even increase in value.

Is a flat a good store of value? If you live in a place where real estate prices are known to not go down over time, then yes.

But let’s refine our definition of a store of value a bit more. We know for a fact that in general, our world experiences inflation. Maybe 2% per year? This means the price of a basket of essential goods (bread, rice, kitchen towels, water) where we live, goes up in price 2% every year. A good store of value, will not only keep its value over time, but it will keep its value relative to inflation over time i.e. it will increase in value at least as much as inflation (the cost of an essential basket of goods) every year, so that it does not lose value versus the cost of our daily life. This is not saying much in today’s developed countries, where inflation is very low, but take for example places like Nigeria, where inflation hovers between 10 and 15% per year (in 1995 it was 70%/year… prices almost doubled every year). If inflation is 10% where you live, it means that an amount of gold that buys you 100 essential products this year, will only be able to buy you 90 essential products next year (100 essential products minus 10% equals 90 essential products) i.e. your gold lost in value for you, because the prices of essential goods went up 10% and therefore the same gold buys you 10% less things.

We need to therefore check two things:

1. See if, since 1971, gold’s price, in dollars, has stayed the same or increased.

We see a huge increase in the price of gold over time, from around 176 US dollars per ounce in January 1975, to about 1840 US dollars per ounce in July 2020. But we also see that it did not increase every single year, and we even see two periods, 1980 onwards and 2011 onwards, when after two extreme spikes up, the price of gold decreased for a few years.

2. See if, since 1971, gold’s price has increased at least as much as inflation.

*to adjust the price of gold by inflation, you simply divide the price of gold by inflation or the cost of a basket of essential goods.

For example let’s say the price of gold in US dollars was 100 in 2010, and 100 in 2011 (it stayed constant). Let’s further say the cost of a basket of essential goods increased from 30 dollars in 2010, to 35 dollars in 2011. To get the inflation adjusted price of gold, you divide gold by the cost of the basket of essential goods each year i.e. in 2010 the inflation adjusted price of gold was 100/30, and in 2011 the inflation adjusted price of gold was 100/35. We see that gold lost in value between 2010 and 2011 — in 2011 it can buy less things than in 2010, because while its price stayed the same at 100, the cost of living went up. This is why you need your assets to increase at least as much as the cost of living does, otherwise they lose value and afford you less things from one year to the next.

What do we read here?

1. We saw above that the price of gold went up A LOT between January 1975 and July 2020. However, we also know that the cost of living for us all has gotten more expensive since 1975. If we adjust for this cost of living, with the same calculation we did above, the price of gold went from 3.9 in January 1975, to 7.1 in July 2020. The price/value of gold relative to the cost of living doubled in 45 years. Or in other terms, an amount of gold that could buy us 1 bread or naan in 1975, can buy us now 2 breads or naans.

2. We see that this rise was not constant — it is not a straight line sloping upwards. We see periods when the price of gold increased a lot, such as the late 1970s, the early 2000s and 2019–2020. And we see periods when the price of gold decreased such as the 1980s and 1990s. Therefore it does matter when we invest in gold — we can invest “at the right time,” just before it starts increasing like the late 1970s, or at the wrong time, like the peak in 1980, when we would have experienced a long decline in our gold position. Between 1980 and 1985, the price of gold fell 55%, and between 2011 and 2016, it fell 28%.

2. We see peaks in 1980, 2011, and about now. These correspond to periods when people expected a long period of significant inflation to follow. When we have inflation (the price of a basket of essential goods goes up a lot from one year to the next), cash/currencies like the US dollar lose value, so people try to invest in assets like gold instead. However, both the 1980s and 2010s were periods of low inflation, so people who rushed into gold expecting a lot of inflation, were simply wrong. No one could have predicted the future, so there is nothing wrong with that.

b. Inflation hedge

We have seen above that over the past 45 years, gold has been an inflation hedge, increasing in value twice more than the cost of living increased.

And indeed, taking the example of a loaf of bread, Harvey and Erb (2012) argue that gold has maintained its inflation adjusted value from 562 BC in Babylon, when an ounce of gold afforded you 350 loaves of bread, to 2012, when an ounce of gold (valued then at US 1600), also afforded you 350 loves of (expensive) bread. Gold has kept its value in terms of real life costs, such as bread, for 2580 years! Schroders similarly highlights gold’s role as an inflation hedge, both short term and long term.

Over very long periods of time, gold 1. maintains its value (adjusted for the rising cost of living), and 2. in modern history, tends to increase in value (adjusted for the rising cost of living).

However, Martin Feldstein, a renowned economist, correctly points out that in the short term, gold may well not be an inflation hedge i.e. the inflation adjusted price of gold today is still below the peak of 1980 — if you had bought at the peak in 1980, after adjusting for the cost of living, your investment would still be below its original value. As always, buying at the peak, whether gold or Apple shares, is dangerous.

Keep in mind that Erb et al (2013) moderate the role of gold as an inflation hedge by pointing out that in periods of hyperinflation (prices go up by 50% a day or more, or 13000% per year), gold loses in value in local currencies too, albeit a lot less than the local currency/cash (which loses all its value) and other “safe assets.”

c. Stock market/economy hedge and safe haven

A hedge is an asset whose returns are uncorrelated, or even negatively correlated, with other assets. Let’s take the example of stocks and gold. For gold to hedge a portfolio of stocks, its price, in average and over time, needs to behave differently from that of stocks — either increasing a lot more, or a lot less than stocks, or even to increase when the price of stocks decreases. What matters to us the most is that when stock markets tend to fall, the price of gold falls less — or even rises. This way when our portfolio of stocks loses in price, we know that our gold will increase in value, so overall our portfolio, our assets, will lose less in value, or not lose any value, or even gain in value (since gold tends to be a small position in a portfolio, this last scenario is unlikely — realistically we are just trying to lose less than a portfolio of 100% stocks would).

A safe haven is an asset whose returns are uncorrelated, or even negatively correlated, with other assets in times of extreme economic/financial shock — in financial crises. Let’s take the example of stocks and gold. For gold to be a safe haven relative to stocks, when there are financial crises and the stock market plunges significantly, the price of gold needs to either fall a lot less (uncorrelated), or even increase (negatively correlated).

Studying the period 1995 to 2010, Hood and Malik concluded that gold is both a hedge and a safe haven asset relative to stocks (they find however that platinum and silver are not hedges nor safe havens).

Bredin et al (2015), Baur and Lucey (2010), Baur and McDermott (2010), Hillier Draper and Faff (2006), all similarly conclude that gold is a hedge and a safe haven asset.

Crise (2017) concluded that gold has a significant inverse correlation to market volatility i.e. when markets become volatile, when investors are afraid, gold price tends to go up. To support his point, he identified 10 serious market shocks over the three decades beginning 1987 and ending 2017. I removed one ( Taper Tantrum of 2013, results were in line with the rest but it is less well known and understood by the general public) and added the Covid pandemic financial shock, defined as last day of February 2020, to March 23rd when US markets reached their bottom:

What do we see in this table? When there are serious financial crises, and the stock market loses a lot of value, gold, on the contrary, goes up in price. When you buy gold therefore, you can reasonably expect that the next time there will be a crisis and your stock portfolio will lose in value, gold will gain in value.

d. Portfolio diversifier

This takes us to gold as a portfolio diversifier. For an asset to be a portfolio diversifier, it needs to behave differently from other assets. We saw above that gold certainly behaves differently from stocks. Furthermore, gold is generally accepted to be uncorrelated to other asset classes, not only stocks, which we’ve seen, but also bonds and real estate (Lioudis, 2020). Erb et al. (2013), in their well known article on gold, concluded that over time gold has low correlations with other asset classes such as stocks and bonds. And the large bank Schroders, in its publications, further reinforces this role of gold as a portfolio diversifier.

Crise concludes that over the 30 years 1987–2017, a portfolio of 55% stocks, 35% bonds, and 10% gold, would have performed 55 bps (0.55%) better per year than a portfolio of 60% stocks and 40% bonds. This is a small amount per year, but a very large difference over 30 years. Professional investors work very hard for an extra 0.50% return on their portfolios!

e. apocalypse

There is a community of people who hold synthetic gold (gold stocks), and especially physical gold, for the small chance of an apocalypse scenario — political upheaval, social unrest… You may laugh but for many people on the planet these are unfortunately very real possibilities, present in their daily lives. And when you see the number of wealthy people in the US and Europe holding physical gold in bank vaults, buying houses in New Zealand, and owning bunkers here and there, you wonder if it doesn’t make sense for everyone else to consider these possibilities too. If something is not completely impossible, you should think about it. Should such scenarios unfold, gold is one of the few means of exchange that is accepted across the whole planet and that doesn’t lose value as local governments come and go and local currencies are changed and devalued.

*Inflation Nigeria:

https://data.worldbank.org/indicator/FP.CPI.TOTL.ZG?locations=NG